Mercer Capital | Bank Valuation Basics
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Transcript of Mercer Capital | Bank Valuation Basics
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Bank Valuation BasicsJay D. Wilson, CFA, CBAFebruary 19, 2013Mercer Capital Depository Institutions Group
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About Mercer Capital
Overview
Mercer Capital is a national business valuation and financial advisory firm.
Our clients include private and public operating companies, financial institutions, asset holding companies, high-net worth families, and private equity/hedge funds.
Mercer Capital’s technical discipline of providing well-grounded valuation opinions is buttressed by real world experience gained in providing advisory services. Likewise, the market-centered orientation of financial advisory services has as its foundation a keen understanding of valuation drivers.
Services
Valuation Advisory & Opinions
Corporate Transactions
Financial Reporting
Employee Benefit Plans
Tax Compliance and Reporting
Litigation Support
Financial Advisory
Corporate and Strategic Advisory
Mergers & Acquisitions
Fairness Opinions
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Outline for Today’s Presentation
Part One:Community Banks
Part Two:Valuation
Q&A
Overview
Financial Statement Basics
Recent Industry Trends
Overview
Guideline Public Company Method
Guideline Transactions Method
Discounted Future Benefits Method
Special Issues
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Community BanksOverview
Financial institutions include several kinds of financial entities
Depository Institutions - Banks, bank holding companies, saving banks, mutual savings banks, stock-owned thrift institutions, mutual thrift institutions, and credit unions
Asset managers – RIAs, hedge fund managers, PE managers, broker/dealers, etc.
Insurance companies – Agencies, Underwriters, Ancillary (Administrator/Claims Adjusters)
Specialty Finance and Real Estate Companies
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Community BanksOverview
Depository institutions have several common characteristics
Accept deposits from consumers and/or businesses
Deposits are generally insured by the federal government
Chartered by federal government or various states and regulated by agencies of these government
Generally deploy the acquired deposits by making loans to customers, either businesses or consumers, or making other investments that provide earnings
Community banks are a subset of this group
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Community BanksOverview
What is definition of a community bank?
Lots of different definitions
Historically, definition has been banks with less than $1 billion in assets
FDIC definition is a bit more broad (FDIC Community Banking Study – December 2012)
Definition focuses on traditional lending and deposit gathering and limited geographic scope
Based on FDIC definition, 7,658 FDIC insured community banks operating within 6,914 separate organizations
Other interesting notes from FDIC study
Multi-decade consolidation trend - 17,901 federally insured banks in 1984 to 7,357 in 2011
Share of industry assets held by community banks has declined. Banks with assets greater than $10 billion control 80% of industry assets in 2011 compared to 27% in 1984
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Community BanksOverview
Banks vs. Operating Companies
Key Similarities
The goal is to provide a return on capital invested
Key Differences
A bank’s success or failure has a more direct link to the balance sheet
In operating companies, this link is less clear as issues such as marketing, technological innovation and market position can be more important than financial structure
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Community BanksFinancial Statement Basics
AssetsLiabilities and
Stockholder’s Equity
Securities Portfolio
Loan Portfolio
Loan Loss Allowance
Earning Assets
Cash
Plant, Property, and Equipment
Intangible Assets
Total Assets
Demand Deposits
Time & Savings Deposits
Total Deposits
Fed Funds Purchased
Long-term Debt
Total Liabilities
Common Stock
Stockholder’s Equity
Total Liabilities and Stockholder’s Equity
Balance Sheet Overview
Assets consist primarily of cash and equivalents (vault cash, deposits at other banks, Fed Funds sold), investment securities, and loans
Liabilities mostly consist of deposits
Banks do not have distinction between current and long-term assets and liabilities
Key difference from operating company
Inherent leverage in business structure
to support functioning of bank loans
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Community BanksFinancial Statement Basics
Total Securities Interest Income
Trading Account Loans
Fed Funds + CDs + Rev Repos Fed Funds Sold & CD's
Gross Loans & Leases Securities
Loan Loss Allowance Estimated Tax Benefit
Net Loans & Leases Interest Income (FTE)
Total Earning Assets
Interest Expense
Cash and Due From Banks Deposits
Bank Premises Fed Funds Purchased
Other Real Estate Owned Other Interest Expense
Intangible Assets Interest Expense
Cash Surrender Value of Life Insurance Net Interest Income (FTE)
Other Assets
TOTAL ASSETS Fee IncomeDeposit Account Service Charges
Other Operating Income
Total Other Income
Non-Interest Operating Expense
Salaries & Benefits
Net Occupancy
Other Operating Expenses
Non-Interest Operating Expenses
Security Transactions
Loan Loss Provision
Pre-Tax Income
Taxes
NET INCOME
Since a bank’s balance sheet drives its income statement, let’s start with the balance sheet
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Community BanksFinancial Statement Basics
Key Balance Sheet Items
Loan/Deposit or Loan/Asset Ratios – one measure of the risk of a bank. A high loan/deposit ratio signals potentially higher liquidity risk. Low ratios signal less liquidity and credit risk, but at the expense of lowering profitability
Loan Portfolio Composition – extent of diversification among multiple types of loans
Loan Loss Reserve - reserve to cover probable loan losses in the portfolio. The loan loss reserve is reduced by loan losses and replenished by a charge to earnings
Non-Performing Assets – an asset that the bank has deemed to present greater-than-average risk of loss
Capital – the “cushion” available to absorb losses that occur or expand the bank’s assets. Banking regulations provide benchmarks for capital levels
Capital adequacy is key
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Community BanksFinancial Statement Basics
Net Interest Income Interest Income-Interest Expense Most of banks’ revenues Must maintain spread between
rates earned and rates paid
(+) Non-Interest Income Complements interest income and
helps offset expenses Important for growth and
diversification
(=)Total Revenues
Total Revenues
(-) Non-Interest Expenses Expenses not related to interest
often occur during expansion and can be analyzed using the efficiency ratio
(-) Loan Loss Provision Charge to replenish loan loss
reserve
(-) Income Taxes
(=) Net Income
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Community BanksFinancial Statement Basics
Key Ratios
Return on Equity
Net Income/Equity
Measures how productively the bank invests its capital
Return on Assets
Net Income/Total Assets
Measures the productivity of the assets deployed by the bank
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Community BanksFinancial Statement Basics
Risk Factors
Credit Risk - potential that some of a bank’s investments, in either loans or securities, may not be repaid according to their terms
Interest Rate Risk - changes in net interest income or the change in the value of net assets caused by changes in market interest rates
Liquidity Risk - bank’s ability to meet its obligations, such as commitments to fund loans or deposit withdrawals, in the ordinary course of business
Results from loans not being immediately marketable, such that a highly “loaned-up” bank may not be able to pay off maturing deposits
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Community BanksFinancial Statement Basics
Banks are highly regulated entities
Another key difference from most operating companies
Key regulatory agencies include:
Federal Deposit Insurance Corporation (FDIC) - guarantees safety of insured deposits with banks, through the Deposit Insurance Fund
Office of the Comptroller of the Currency (OCC) - chief regulator officer for national banks and is responsible for governing the operations of national banks; assesses financial condition, soundness of operations, quality of management, and compliance with federal regulations
Federal Reserve - central banking system of the U.S.; also regulates bank holding companies
U.S. Securities and Exchange Commission (SEC) - enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets
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Community BanksFinancial Statement Basics
Basel III Capital Regulations
Core equity requirements are increasing
Minimum 7.0% tier one common with 2.5% buffer
Minimum 8.5% tier one and 10.5% total capital
Push to reduce parent company leverage
Trust preferred phase-out
Parent companies to hold more liquidity
Reworking of asset risk weights creates potential issue
Heavier risk weighting for NPAs creates pro-cyclical capital requirements
Community banks are heavily invested in CRE
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Community BanksRecent Industry Trends
Current challenges
Yields under NIM compression via Fed’s zero interest rate policy
Loan demand weak in most regions
Mortgage gains are supporting fee income, but the refi wave may fade
Operating leverage is tough to achieve given pressure on revenues and rising compliance expenses
Regulatory expectations regarding higher capital ratios (and more common equity within the capital structure)
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Net Interest Margin
61% of the banks had a lower YTD NIM vs. last YTD thru 9/11
More pressure to come given loan pricing competition and low reinvestment rates for bond cash flows, while COF leverage is limited
Peer group consists of approximately 3,600 banks with assets between $100 million and $5 billion
Source: Mercer Capital Presentation at AOBA Conference “Capital Management: Alternatives & Uncertainties”
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Efficiency Ratio
Operating leverage is directionally negative post-crisis
Small banks are at a competitive disadvantage
Efficiency Ratio = Non-Int’t Expenses / (Net Int’t Income + Non-Int’t Income) Source: Bank Holding Company Performance Reports
Assets > $10B Assets $3-10B Assets $1-3B Assets $500M - $1B55%
60%
65%
70%
75%
80%
2005 2009 2012
Source: Mercer Capital Presentation at AOBA Conference “Capital Management: Alternatives & Uncertainties”
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Credit Costs
Credit-related costs have trended down, offsetting pressure on PPOI
But … credit leverage is limited going forward
Peer group consists of approximately 3,600 banks with assets between $100 million and $5 billion
2004Y 2005Y 2006Y 2007Y 2008Y 2009Y 2010Y 2011Y YTD @ 9/11
YTD @ 9/12
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
50.00%
Loan Loss Provision + OREO / PTPPPO Income Pre-Tax, Pre-Provision, Pre-OREO Income / Avg. Assets
Pre
-Ta
x,
Pre
-Pro
vis
ion
, P
re-O
RE
O I
nc
om
e /
Av
g.
As
se
ts
Lo
an
Lo
ss
Pro
vis
ion
+/-
OR
EO
Lo
ss
es
/Ga
ins
/ P
TP
PP
O I
nc
om
e
Source: Mercer Capital Presentation at AOBA Conference “Capital Management: Alternatives & Uncertainties”
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Return on Equity
ROE has rebounded
70s & 80s saw ROE volatility via three recessions and sharp rate moves
90-06 “great moderation”
Source: FDIC
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Assets > $10B Assets $1-10B
Source: Mercer Capital Presentation at AOBA Conference “Capital Management: Alternatives & Uncertainties”
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Return on Tangible Equity
YTD through September 2012, ~50% of the bank holding companies surveyed reported ROTE of 0-10%, representing the highest proportion over the 1991 to 2012 period
Proportion with negative ROEs fell from 41% in 2009 to 10% in 2012
Data set includes bank holding companies filing Form FR Y-9C with less than $5 billion of assets at September 30, 2012 (approximately 1,000 holding companies) Source: Mercer Capital Presentation at AOBA Conference “Capital
Management: Alternatives & Uncertainties”
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Three Key Elements of Valuation
Cash Flow Risk Growth
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ValuationOverview
Valuation is, by its nature, forward looking
Value is a function of estimates of future cash flows, risk and growth, which may or may not necessarily coincide with historical performance
However, historical measures can often help predict (or confirm other estimates of) future cash flows, risk, and growth
Any prediction of the future depends on the quality of the inputs
Appropriate adjustments to historical financial metrics can aid in making better predictions of future earnings
But what is an “appropriate” adjustment?
Valuation is a range concept
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ValuationOverview
There’s also an interaction between the three valuation elements
Short term cash flows and growth can be enhanced by taking more risk (of the credit or interest rate variety)
Keep in mind that earning power is in some sense a long-term concept, not necessarily a prediction of the next quarter’s or year’s earnings.
Impact of assuming an inappropriate level of risk is usually not immediately evident
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ValuationOverview
Community banks differ from larger banks
Composition of revenues – non-interest income often accounts for a smaller proportion of total revenue
Composition of loan portfolio – greater dependence on particular type of lending (often commercial real estate and construction loans)
Capital structures – not as leveraged. Regulatory capital requirements filled to a greater extent by components other than common equity
Diversification – not as diversified, as measured by geography, customer, etc.
Can cut both ways. A number of largest banks very diversified by product and geography but had major write-downs in financial crisis. Community banks may know their customers and understand the risks they are assuming better
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ValuationOverview
Community banks can differ from publicly traded community banks
Capital structure – private banks are more likely to have inefficient capital structures (excess equity over public banks and regulatory requirements)
Returns – more likely to see poor returns persist for longer periods of time
No activist shareholders to push them to sell
Location – rural vs. metropolitan. Most of the larger, public banks have pushed to expand in metro markets
More “weird” stuff
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ValuationOverview
Source: www.mercercapital.com
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ValuationOverview
Valuation Approaches
American Society of Appraisers (ASA) recognizes three general approaches to valuation
Asset Approach
Income Approach
Market Approach
Within each approach, there are a variety of methods that appraisers use to determine value
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ValuationOverview
Asset Approach
» “… a general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods based on the value of the assets net of liabilities.”
» Methods include: Net Asset Value
Income Approach
» “… a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods through which anticipated benefits are converted into value.”
» Methods include: Discounted Future Benefits
Market Approach
» “… a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interest, securities, or intangible assets that have been sold.”
» Methods include: Transactions, Guideline Public Company, and Guideline TransactionsSource: ASA Business Valuation Standards, Published in
November 2009
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ValuationOverview
Common Valuation Methods Applied When Valuing Banks
Market Approach
Transactions Method
Guideline Public Company Method
Guideline Transactions Method
Income Approach
Discounted Future Benefits Method
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31
ValuationGuideline Public Company Method
Value equals product of following inputs
Financial Metric
Multiple
Both the financial metric and/or multiple may be subject to adjustment
Typically consider multiples of earnings, forward earnings (i.e., budgeted), and tangible book value
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32
ValuationGuideline Public Company Method
Start with universe of public banks
Segment further by screen for
Size
Geography
Difficult to find a good group for more rural banks
Profitability (ROA, ROE, etc.)
Loan composition
Growth (loans, EPS, etc.)
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33
ValuationGuideline Public Company Method
What if there is still no good group of comparable companies?
Start with a group of banks that is at least somewhat comparable (say, $300 - $500 million in assets and a ROE > 10%)
Select a multiple
Statistical approach (pick a multiple at the lower quartile instead of the median)
Adjust the median/average multiple judgmentally
Guideline transactions (i.e., merger and acquisition activity) can also sometimes serve as a reference point
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34
Guideline Public Company MethodPublic Market Historical Trends
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Price / Earnings
13.4222768600
459
16.7573890564
412
18.3023477777
778
16.6197183098
592
17.7127659574
468
14.2795137628
554
13.5329949238
579
14.3146827777
778
13.4782608695
652
11.5646259740
26
12.0186046511
628
Price / Tang. Book Value
1.52886470535
585
2.02549952585
917
2.17120022091
019
1.86028146851
941
1.85878311369
972
1.40607947760
178
1.39928277191
127
1.26648469072
197
1.20893033828
5
1.04959875231
917
1.14413779156
286
1.0
3.0
5.0
7.0
9.0
11.0
13.0
15.0
17.0
19.0
0.30
0.90
1.50
2.10
2.70
Price/Earnings and Price/Book Value MultiplesBanks with Assets of $500 Million - $5 Billion & Return on Tang. Equity Between 5% and 15%
Pri
ce
/Ea
rnin
gs M
ultip
le
Pri
ce
/Ta
ng
ible
Bo
ok V
alu
e M
ultip
le
2002-2012 Medians:P/E: 14.28xP/TBV: 1.41x
Source: Mercer Capital Research, SNL Financial
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ValuationGuideline Public Company Method
Source: Mercer Capital Research & SNL Financial
Pricing as of February 15, 2013 (Financial info through Dec. 31, 2012)
< -10%
0 to -10%
0 to 10%
> 10%
- 0.50 1.00 1.50 2.00
Return on Tangible Equity
Price / Tangible Book Value
Price/Earnings X Return On Tangible Equity = Price/Tangible Book Value
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ValuationGuideline Public Company Method
Source: Mercer Capital Research, SNL Financial, Pricing as of February 15, 2013 (Financial info through Dec. 31, 2012)
< 3%
3 to 6%
6 to 9%
> 9 %
- 0.50 1.00 1.50
Asset Quality
Price / Tangible Book Value
Non-P
erf
orm
ing A
ssets
/ L
oans
+ O
REO
< $1BN
$1 to $5 BN
$5 to $10 BN
> $10 BN
- 0.50 1.00 1.50 2.00
Total Assets
Price / Tangible Book Value
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Guideline Transactions Analysis
Perhaps easier to apply to a small bank than a larger bank due to fact that most transaction activity involves smaller banks
Can tailor the analysis relatively closely to the subject bank’s location, size, performance, etc.
Trade-off is the timeliness of data.
Consider multiples of earnings, tangible book value, and core deposits
37
38
Guideline Transaction AnalysisNon-Assisted Bank & Thrift Acquisitions 1990-2012
38
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
0
50
100
150
200
250
300
350
400
450
500
550
600
$0
$50
$100
$150
$200
$250
$300
217
305
399
481
566
463458463
504
357
280261
232272
283278
309 323
177 175
216 215233
Bank & Thrift Transactions Deal Value
Ba
nk
& T
hri
ft T
ran
sact
ion
s
De
al V
alu
e (
$B
)
Source: Mercer Capital Research (“Outlook for Bank M&A in 2013 Presentation”) & SNL Financial
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Guideline Transaction AnalysisM&A Multiples – P/E and Price/TBV
39
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
10x
14x
18x
22x
26x
30x
34x
38x
42x
46x
50x
50%
75%
100%
125%
150%
175%
200%
225%
250%
275%
300%
Price / Earnings Price / TBV
Pri
ce
/ E
arn
ing
s
Pri
ce
/ T
BV
NM
Source: Mercer Capital Research (“Outlook for Bank M&A in 2013 Presentation”) & SNL Financial
40
Guideline Transaction AnalysisPrice/TBV vs. ROTE
0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x-30%
-20%
-10%
0%
10%
20%
30%
Bank and Thrift Transactions2012 to 2/6/2013
Price/Tangible Book Value
RO
AE
Source: Mercer Capital Research (“Outlook for Bank M&A in 2013 Presentation”) & SNL Financial
41
ValuationDiscounted Future Benefits Method
Relies upon a projection of future financial performance
Requires following inputs Interim cash flows to shareholders/investors (dividends)
Amount necessary to be retained for the bank to achieve its target capital structure (based on a target capital ratio)
A “terminal” or “residual” value Represents value of all cash flows received after the end of the forecast
period
Discount rate
Discounting convention
Value equals the sum of the present value of the cash flows (#1 and #2 above), discounted at the discount rate
41
42
ValuationDiscounted Future Benefits Method
DCFs are helpful in certain circumstances: Near-term growth is expected to exceed long-
term expectations
Near-term profitability is low/high and is expected to revert to a mean
Capital structure may change in the future
42
43
Valuation Special Issues
Possible ways to handle need for an adjustment:
When Estimating Financial Metric
Adjust the subject bank’s income statement and balance sheet
Estimate earning power via normalized ROA or ROE
When Estimating Multiple
Adjust multiple derived to account for risk and/or growth differentials
Carve out part of the business and value separately
44
Valuation Special Issues – Common Adjustments
Income Statement
» Eliminate non-recurring gains and losses
» Eliminate other income and expense items
» Recognize normalized loan loss provision (i.e., greater than net charge-offs)
» Normalize tax rate
» Purchase accounting amortization
» Life insurance proceeds
Balance Sheet
» Adjust for unrealistic valuation of assets
Securities
Investments in other companies carried at cost or equity
» Recognize estimated cost of settling contingent liabilities
» Normalize loan loss reserve
» Adjust intangible assets
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Valuation Special Issues
S corporation banks
Bank itself records no corporate income taxes (taxes “pass through” to and are paid by shareholders)
Tax effect earnings as if it were a C corporation, because multiples are derived from public C corporations
Benefit of S election (avoidance of double taxation on shareholder distributions can be captured in the marketability discount)
45
46
Valuation Special Issues
Marketability Discount
Market Approach – Restricted stock studies, pre-IPO studies
Income Approach – Project cash flows over the expected holding period of the investor. Discount cash flows to present at a higher rate that reflects incremental risk of illiquidity
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Valuation Special Issues
Source: SNL Financial, Pricing as of February 15, 2013 (Financial info through Dec. 31, 2012)
Weekly Trading Assets
NPAs / Loans+OREO ROTCE
< 0.5% 733,895 4.01 5.83
0.5 to 1.0% 1,700,931 3.10 9.81
1.0 to 2.0% 2,823,692 3.07 9.82
> 2.0% 14,913,012 2.08 11.65
< 0.5%
0.5 to 1.0%
1.0 to 2.0%
> 2.0%
- 0.50 1.00 1.50 2.00
Trading Volume
Price / Tangible Book Value
Weekly
Tra
din
g V
olu
me / S
hare
s O
uts
tandin
g
48
Valuation Special Issues
Weightings
Holding Company & Bank
Options
Unique Capital Structure
Trust Preferred, Preferred (TARP, SBLF, Other), Types of Common (Voting/Non-Voting, Different Classes)
48
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Web Resourceswww.fdic.gov
Contains deposit market share data for all FDIC insured banks by geographic area
www.fdic.gov/sod/index.asp
Contains the FDIC Quarterly Banking Profile, which provides a comprehensive summary of financial results for all FDIC-insured institutions and trends in banking industry
www.fdic.gov/qbp/index.asp
www.ffiec.gov
Provides access to regulatory filings (Call Reports, FR Y-9Cs, FR Y-9LP and FR Y-9SPs for FDIC-insured financial institutions
www.ffiec.gov/reports.htm
Provides Uniform Bank Performance Report, a report detailing performance and composition data for subject bank relative to peer group
www.ffiec.gov/UBPR.htm
www.snl.com
Subscription site
Provides data and industry news (comparable to Bloomberg but primarily dedicated to financial institutions)
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Questions?
Jay D. Wilson, Jr., CFA, [email protected]
Mercer Capital5100 Poplar Avenue, Suite 2600Memphis, TN 38137901.685.2120
www.mercercapital.com